In the last edition of our newsletter, we discussed the correlation between commodity prices and construction costs and that during periods of escalating commodity prices property owners can find themselves underinsured as the cost to replace certain types of assets escalate. In periods such as these many property owners question why they should be ensuring their buildings or equipment for a higher value when they are aware that the market value of their property may not have appreciated to the same degree or in some cases may have even declined.

While this is counter intuitive, property owners need to be cognizant of the difference between market value and replacement or insurable value. Market value, as determined by an accredited appraiser, repre-sents the probable price that would be realized for a specified property at a specific point in time, if offered for sale on the open market Generally speaking, market value is arrived at through an analysis and recon-ciliation of the market environment, the investment characteristics of the property, and its depreciated replacement value of the improvements. Reconstruction costs are the basis for determining replacement or insurable values and include an analysis of the labor, materials, equipment and other costs required to reproduce a property (or piece of equipment) of like kind and quality in the same location.

While there has been little research on the relationship between market and replacement values, the graph below produced by Robert Shiller of Yale University charts U.S. home prices against construction costs, population growth and interest rates since 1880. What is evident from this research is that there is little relationship between building costs and housing prices and there have even been periods where the two are negatively correlated. In fact, despite the steep decline in U.S. housing prices over the past couple of years there continues to be a general escalation in building construction costs across the country.